When will the US Federal Reserve start to incorporate Donald Trump’s policy plans?

Fed chair Jerome Powell could start to acknowledge the economic impact of Donald Trump’s policy plans but probably more in terms of upside risks to growth, which could be good for stocks.

US Federal Reserve Board chairman Jerome Powell. Picture: Getty Images

It’s a big week for markets with interest rate decisions in five G10 countries, including the US.

Of course, nothing is more important than what the powerful US Federal Reserve Open Market Committee has to say about interest rates and the outlook for monetary policy.

The Fed has already cut its Fed funds rate target range by 75 basis points from the post-Covid peak of 5.25-5.5 per cent, and another 25 basis points cut is widely expected to be announced when officials conclude their meeting at 6am (AEDT) on Thursday.

At the same time, the Fed’s “dot-plot” of interest rate projections is expected to remove 50 basis points of the 1.5 percentage points of cuts that are currently projected over 2025 and 2026.

Uncertainty about the outcome, and expectations that FOMC officials will “take with the other hand” by dialling back their rate cut projections could explain why the 100-year US Treasury yield has risen about 25 basis points and the S&P 500 has stalled near record highs in the past week.

The US benchmark has soared 27 per cent this year on the AI boom, interest rate cuts, and more recently, US economic resilience and the re-election of Donald Trump.

There is also a wide range of estimates among FOMC officials of the “terminal” or “neutral” rate.

The November estimates for neutral rate ranged from 2.4 to 3.8 per cent but some officials have more recently said it could be even closer to near the current Fed funds rate target.

US economic surprises peaked a few weeks ago, but the economy continues to overshoot expectations.

The US doesn’t need major stimulus beyond removing some of the restrictiveness of rates policy. Moreover, the Fed isn’t at risk of undershooting its inflation target in coming years.

If there’s one thing that 2024 has taught us, it’s that economic resilience and the implications for corporate earnings (as well as the AI boom) trumps expectations for interest rates.

After all, the Fed started cutting rates six months later than expected and is set to deliver 100 basis points of cuts in 2024 versus the 180 basis points of cuts that were expected a year ago, yet the S&P 500 has had an extraordinarily good year, rising 27 per cent with nothing more than a 10 per cent dip.

The S&P 500 has stalled near record highs in the past week. Picture: Getty Images

Assuming the Fed cuts 25 basis points and removes 50 basis points of rate cuts from its dot-plot for the next two years as outlined above, the year end “melt-up” in US stocks fuelled by underperforming active managers catching up with the benchmark looks set to continue.

It has been suggested that at this FOMC meeting, chairman Jerome Powell could indicate that Fed officials have started to incorporate Donald Trump’s policy plans into their forecasts.

Heightened focus on the risk of stronger than expected economic growth and inflation could cause the US 10-year bond yield to break above the top of the post-election range of 4.13 to 4.5 per cent.

A break above 4.5 per cent would indicate that the downtrend in the 10-year US bond yield from the peak of 5 per cent in late 2023 has ended and that 5 per cent – a 17-year high for the 10-year bond yield – is set to be retested.

That could upset the sharemarket in the short-term but investors are likely to take advantage of any dips based on their 2025 outlook.

When asked about the impact of Mr Trump’s policy plans – including tax cuts, tariffs and deportations – in November, Mr Powell said: “We don’t guess, we don’t speculate, and we don’t assume.”

But at some point the Fed will have to incorporate the significant policy changes by the government.

The good news is that while there’s a widespread expectation that Mr Trump will extend 2017 tax cuts when they’re due to expire at the end of 2025, there’s by no means widespread expectations that he will carry out the full extent of his immigration and trade plans.

“We (the Fed) can’t make policy based on conjecture,” Ray Attrill, head of FX research at NAB, said.

“We know that policy changes are going to be coming, but can you really make an assumption about tariffs? Can you really make an assumption about we’re going to have mass deportations, of undocumented migrants? It’s really hard, I think, to do that.”

So perhaps Mr Powell will just concede in his press conference that extending the tax cuts would help the economic growth outlook, or perhaps FOMC officials will boost their economic growth forecasts.

But there’s no way that Mr Trump’s immigration or trade policy plans are clear enough for Mr Powell to warn of higher inflation or for FOMC officials to dial up their inflation forecasts.

“I think you just have to say, when the facts change, we’ll change our forecasts, but obviously there has to be some incorporation about what whether we’re going to see a fiscal impulse, or whether we’re seeing fiscal headwinds, and perhaps as they (the Fed) do,” Mr Attrill added.

“The view is that there might be some acknowledgment there, that the Fed do think they can incorporate some assumptions about taxes, which means fiscal policy which otherwise was set to be quite a significant headwind come the end of 2025 when those tax cuts expire, maybe much less.”

On top of that, he expects 25 basis points of cuts to be removed from the dot-plot for 2025 and 2026 and perhaps a quarter point increase in the median estimate for the terminal Fed funds rate.

So the bond market could find a reason to push the 10-year bond yield above 4.5 per cent but it probably won’t stop the S&P 500 from hitting fresh record highs before year end.

Originally published as When will the US Federal Reserve start to incorporate Donald Trump’s policy plans?